Payroll Taxes Are "Regressive"? Time to Rethink That Idea

November 1, 2012

In the discussion of taxation, one contentious issue has been whether the rich pay their fair share, say Kip Hagopian, the chairman of Maxim Integrated Products Inc., a semiconductor company, and Lee E. Ohanian, professor of economics at UCLA and a senior fellow at the Hoover Institution.

Some, including New York Times columnist Paul Krugman, point to how Social Security and Medicare are funded, stating that "the payroll tax is regressive, as are most state and local taxes, which largely offsets the progressivity of the income tax." However, studies show that the Social Security and Medicare programs, viewed as a whole, are anything but regressive.

The payroll taxes that fund these programs are collected for the express purpose of providing income supplements and medical care during retirement. In the case of Social Security, earned income is taxed proportionately at 12.4 percent (split evenly between employee and employer) up to a cap that is currently set at $110,100. Those who assert that the Social Security tax is regressive note that the income cap results in a decline in taxes paid as a percentage of income as income rises above the cap. But this observation omits three critical facts:

First, the amount of one's Social Security income at retirement is also capped.

Second, higher-income workers receive less of a benefit as a percentage of their contributions than do lower-income workers. The payouts to retirees are, and are intended to be, redistributive.

Third, Social Security income is subject to the income tax -- and the income tax is progressive.

Given the design of Social Security, the only way the program could be regressive is if the mortality rate differences between the group of higher-income and lower-income workers were so large that higher-income people received greater lifetime benefits for each dollar contributed. But this is not the case, according to a 2009 study by the Social Security Administration's Office of Retirement and Disability Policy.

In the case of Medicare, the amount paid into the system -- 2.9 percent of income, split evenly between employee and employer -- is proportionate to income and has no cap. So a person with a lifetime income of $5 million will pay five times as much into the system as a person with a lifetime income of $1 million.

Those who would increase the marginal rates paid by the top income earners must confront the depressing effect that higher taxes will have on business creation and expansion -- and on jobs. Giving a bigger piece of a smaller economic pie to lower-income earners is not likely to be in America's interest.